Understanding Residential Mortgage-Backed Securities | CFA Level I Fixed Income

Residential Mortgage-Backed Securities (RMBS) are a popular type of asset-backed security. In the US, RMBS are divided into three sectors:

• Securities guaranteed by a federal agency, such as Ginnie Mae
• Securities guaranteed by government-sponsored enterprises (GSEs), like Fannie Mae and Freddie Mac
• Non-agency RMBS issued by private entities

Agency vs. Non-Agency RMBS

Agency RMBS are backed by a federal agency or GSE, while non-agency RMBS are issued by private companies. The main differences between the two include:

• Credit risk reduction: Agency RMBS have reduced credit risk due to GSE guarantees, while non-agency RMBS use credit enhancements.
• Underwriting standards: Loans in agency RMBS must meet specific criteria, while non-agency RMBS can include non-conforming mortgages.

Breaking Down an RMBS Example

Prepayment Risk and CPR

Prepayment risk arises when borrowers make unscheduled mortgage payments, causing unpredictable cash flows for RMBS investors. To account for this, issuers estimate an expected prepayment rate (CPR). A CPR of 15% means that 15% of the outstanding mortgage balance is expected to be prepaid by year-end.

In the US, CPR is compared to the Public Securities Association (PSA) prepayment benchmark. A PSA of 100 means the MBS is expected to have prepayment rates that match the benchmark. Higher PSA values indicate faster prepayments and shorter average lives, while lower PSA values indicate slower prepayments and longer average lives.

Contraction and Extension Risk

Market interest rate changes can significantly impact prepayment rates:

• Contraction risk: If market interest rates fall, prepayment rates increase, and the average life of the RMBS is shorter than expected.
• Extension risk: If market interest rates rise, prepayment rates decrease, and the average life of the RMBS is longer than expected.

In our example, the underwriters estimated a PSA of 250 for the RMBS. However, actual prepayment rates may differ from expectations due to market interest rate fluctuations, resulting in either contraction or extension risk.

Investor Preferences and Reallocating Prepayment Risk

When it comes to residential mortgage-backed securities (RMBS), handling prepayment risk effectively is crucial. This can be done by reallocating the risk according to investor preferences, such as in our earlier example:

EXAMPLE: Mario is fine with contraction risk, but not extension risk. Kim, on the other hand, prefers the opposite. To accommodate both investors, a mortgage passthrough security’s cash flow can be divided into two tranches.

Tranching and Collateralized Mortgage Obligations (CMO)

A time tranching structure can be used to redistribute cash flows in RMBS, resulting in collateralized mortgage obligations (CMOs). These are structured as sequential pay tranches, with each tranche retired in order before the next tranche receives principal repayments. This differs from credit tranching, which distributes credit risk amongst tranches.

EXAMPLE: We can analyze how prepayment risk distribution works in a sequential pay CMO with two tranches. Tranche A is the short tranche, providing more protection against extension risk but higher exposure to contraction risk. Tranche B is the long tranche, offering more protection against contraction risk but higher exposure to extension risk.

Planned Amortization Class (PAC) CMOs

For investors seeking protection against both extension and contraction risk, a planned amortization class (PAC) CMO may be more appropriate. PAC tranches have their prepayment risk reduced by increasing the prepayment risk of the CMO’s support tranches. These tranches work within an initial collar, with the support tranche absorbing faster or slower prepayments up to a certain limit.

Non-Agency RMBS and Credit Enhancements

Non-agency RMBS are issued by entities other than Ginnie Mae, Fannie Mae, or Freddie Mac, and are not guaranteed by the government. As a result, credit risk becomes an important consideration. Credit enhancements, such as credit tranching and other mechanisms, play a vital role in obtaining favorable credit ratings and making non-agency RMBS more marketable to investors.

With this knowledge of residential mortgage-backed securities and their risk management strategies, you’re well-prepared for the next lesson on commercial mortgage-backed securities.